Why Russia and China should be on your hit list for equities

For some time now we have used the chart below to describe relative country valuations among developed and emerging equity markets. The best way to know if a process has any merit is to track it. Starting today, we shall begin tracking a long-short portfolio of the model's most underrated and overvalued countries.

Source: Bloomberg, Saxo

Country valuation model

The model is quite simple. It reflects the coherent relationship between the return on equity to the cost of equity spread and price-to-book ratio. The higher the return on equity relative to the cost of equity, the higher the justified price-to-book ratio.

Return on equity is calculated using 12-month expectations for earnings. The cost of equity is based on the US equity risk premium (currently 5.1 percent), US risk-free rate (10-year Treasury yield) and S&P 500 volatility; all other equity markets' cost of equity are then scaled relative to the US cost of equity based on volatility.

Price-to-book ratio is based on the latest available book value per share and share price. The observed values in the global equity market is then fitted and based on this as a relative ranking occurs. Based on this relative ranking, views are formed on all 44 developed and emerging equity markets.

Portfolio composition

Based on the model, the following countries are the five most underrated and overvalued among developed and emerging equity markets. It is worth mentioning that only two countries out of 44 nations do not have ETFs tracking their performance. Those two are the Czech Republic and Hungary and are excluded from being included in the portfolio as we only want exposure to countries that are eligible for trading.

As the table shows, the five most undervalued equity markets in the world are currently Russia, China, South Korea, Austria and Singapore. The five most overvalued equity markets are India, the Philippines, Mexico, Indonesia and Greece. Regarding the high 12-month forward P/E ratio for Greece, it is currently an expression that earnings expectations are very small relative to the index's share price.

The portfolio is equally weighted and we shall be tracking the performance on a weekly basis reporting on Mondays or the following business day. The ticker codes in the table are the ones that should be used in the SaxoTrader. Any changes to the portfolio are undertaken every Friday afternoon in the European session.

-- Edited by Kevin McIndoe

Peter Garnry is the Head of Equity Strategy at Saxo Bank. Please check out his articles and trades here on our exciting copy trading platform.

Not all country ETFs are eligible for CFD trading and thus shorting. It is thus very likely that shorting the most expensive markets are not possible on the SaxoTrader. Going forward we will still be tracking the long-short portfolio to showcase the model, but we will also show the long-only performance against the MSCI World Index.

Here is the full list of all 44 equity markets. The percentages are the distance to the regression line, but since the system is dynamic and we do not assume perfect fit, the percentages should not be interpreted as the forecasted returns per se. I would rather see them as a relative strength indicator signalling how much over- or undervalued a market is relative to the others.

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